Confessions of Chinese Derivatives Deals

飞雪寒冰

Even America's most famous investor, Warren Buffett, admits he got burned by derivatives during the global financial crisis. And if he didn't know what he was doing, imagine what could happen in the future to Chinese companies.

Many Chinese firms had little experience with complicated financial products such as derivatives before they bought billions of dollars worth of these investment products. Many of these investors, especially small to medium-sized companies, could see their profits wiped out, and may face bankruptcy if their investments explode.

飞雪寒冰

Why do I think this? Because I helped create these derivatives. I'm an American from Texas who worked for about a decade for international banks and law firms. Derivatives experts sought me out because I'm a lawyer with a degree in mathematics. I spent thousands of hours in Hong Kong skyscrapers translating the calculations and cash flows into arcane, legal English. And I eventually figured out how the banks -- and, I must admit, myself -- could profit by selling products their customers didn't fully understand.

The basic concept behind derivatives is simple. They are financial agreements in which one party agrees to pay another party if a market goes up or down. For example, imagine an airline that buys jet fuel. The airline could face trouble if the price of oil shoots up. To protect itself, the airline can buy a derivative -- a hedge -- that will pay money if the price of oil rises. Of course, if the price of oil drops, then the airline would lose money on its hedge. But, on the other hand, it would also pay less for fuel. You could think of this sort of derivative as a type of insurance.

But in China, the profit margins on simple and safe derivatives fell too far for foreign banks. A couple of years ago, after they sold all the derivatives they could to large Chinese banks and state-owned enterprises, investment banks then targeted smaller Chinese firms. These firms had less money, so the only way for the banks to maintain their profit levels was to make derivatives more complex and risky. My job was to write them.

Many small Chinese companies had taken out loans and wanted to protect themselves against changes in interest rates. A simple hedge would have worked fine. Instead, the banks sold complex derivatives called "cost reduction swaps" that were linked to such obscure factors as differences in euro interest rates. When the credit crunch hit Europe, Chinese clients suddenly had to pay millions of dollars to their investment bankers.

飞雪寒冰

Or consider what happened last summer, when the world believed that the yuan would appreciate. Small manufacturers who earned revenue in foreign currencies worried that their yuan expenses would remain constant while the yuan values of their sales would fall. Banks were eager to help these factories hedge their currency risks, but because everybody in the world believed the yuan would appreciate, it was very expensive to hedge.

So the banks created some tricky products. One popular derivative would arrange payments every month between a bank and company. If the yuan had gone up from the start of the trade, the bank would pay the company. If the yuan had gone down, then the company would pay the bank. These monthly payments would continue for five years. But to make monthly payments more favorable for the company at the start, many banks gave themselves the right to terminate the derivatives earlier than scheduled. If the trade was hurting a bank, it could tear up the contract; if the trade was helping the bank, it could continue to profit -- and the company would have no choice but to continue losing money.

飞雪寒冰

China Eastern Airlines is one notorious case of a perilous hedge. Quite sensibly, the airline bought derivatives that would pay if oil became more expensive. But to make the hedge cheaper in the short term, China Eastern agreed that if oil prices dropped past a certain point, then it would have to pay double what the bank would have to pay if the price of oil went up. After the oil bubble burst last year, the company admitted these derivatives cost them 6.2 billion yuan -- and obliterated their profits for 2008. Of course, China Eastern is a huge company with government support. Most small investors are not as lucky.

By most estimates, at least hundreds of these unnecessarily complicated derivatives remain on the books at Chinese companies. Many are linked to markets that could go haywire at any time. Chinese derivative holders would then face enormous costs that many can't afford. I would urge all companies that bought derivatives to pull the contracts from their files and read the fine print now.

No one forced companies to buy these derivatives or accept the contracts the banks wrote. But the banks always knew so much more than the companies, and they exploited this advantage.

In the end, I decided to leave on my own, to try to make the game fairer and bring derivatives back to their intended purpose. In a future article, I will explain how structural incentives in banks actually encouraged derivatives that were not right for clients. Derivatives in China didn't have to turn out this way.